The Rhetoric and Reality of Shareholder Democracy

The Rhetoric and Reality of Shareholder Democracy was submitted by Jang-Sup Shin for publication in response to my post Predatory Value Extraction, a review of the book of that title by Professors Shin and Lazonick. Comments on The Rhetoric and Reality of Shareholder Democracy are invited in the box below.

The Rhetoric and Reality of Shareholder Democracy

Thank you, Mr. McRitchie, for your kind review of our book. My comment focuses on the history and the nature of shareholder democracy and the current direction of corporate governance, on which we have a view different from yours.

You argue in your comments: “Yes, ‘shareholder democracy’ has turned out badly but it has never been provided with the adequate tools to succeed.” However, shareholder democracy has been around for about a century. The promotion of the concept began in the 1920s under the name of “investors’ democracy,” as Julia Ott has chronicled in her excellent book, When Wall Street Met Main Street: The Quest for Investors’ Democracy (Harvard University Press 2011), and not in the 1950s, as the author of A Nation of Small Shareholders suggests. If shareholder democracy has turned out badly even after a century has passed, it might be worthwhile to address the question of whether shareholder democracy has not been given enough time to develop tools to accomplish its stated mission or it was a project destined to remain problematic.

In our book, Predatory Value Extraction, we maintain the latter view because shareholder democracy started mainly as a political project for social cohesion without economic rationale to support it. Early promoters of shareholder democracy made it clear that “they did not think of it as being related to raising capital” (p. 91). This is also why, before this chapter, we explained the role of the stock market as mainly that of a value-extracting institution, not of a value-creating one (Chapter 3). Public shareholders almost without exception acquire outstanding shares from one another on the secondary market, not by providing companies with capital, doing the latter only on the rare occasions when they purchase shares that companies newly issue. Shareholder activists often demand that capital be “returned” to shareholders, but as public shareholders very seldom contribute capital to corporations, this is not a legitimate claim. In this context, we suggest in our conclusion that we should build a new system of corporate governance reflecting the contribution to value creation by stakeholders.

We agree with you that shareholder democracy “turned out badly” with the growth of institutional shareholding. But we disagree with you on why. We again maintain that this resulted from the inherent shortcomings of shareholder democracy, a concept we regard to be political rhetoric without economic substance. And efforts by shareholder activists like Robert Monks, who relied on the power of institutional investors to make the rhetoric into something substantial, only exacerbated the problem. In imposing compulsory voting on institutional investors, Monks and others envisaged an ideal world where institutional investors take on the role of guardians of shareholder democracy as their power increases and they become more capable of, and interested in, proxy voting and engagement.

However, institutional investors have evolved toward being less capable of and interested in voting and engagement as indexing has become common practice in institutional investing. Currently, indexed funds control about one-third of U.S. public corporations, according to a higher-end estimate, and “If current growth rates continued…, the entire U.S. market would be held by such funds no later than 2030,” projected John C. Coates in his paper “The Future of Corporate Governance Part I: The Problem of Twelve” (2018, p. 13). Equity trading by artificial intelligence (AI) has also moved into the mainstream. A JPMorgan Chase report estimated that AI, including indexing and high-frequency trading, makes up about 60% of stock trading in the United States, and discretionary equity trading accounts for only about 10%. It is impossible to expect that funds managed by AIs would behave as responsible and capable “corporate citizens.”

We do not foresee this trend changing in the future. This is why we called the “corporate governance team” or “stewardship team” within a large institutional investor a “lip-service” organization. Index funds charge extremely low fees because they do not research individual companies. But the imposition of compulsory voting made it necessary for them to show that they were fulfilling this unwanted obligation. These “teams,” limited in staffing but responsible for the huge number of companies in their portfolios, can fulfill their obligations only by applying general metrics. Nor are the capabilities of proxy-advisory firms such as Institutional Shareholder Service (ISS) very different from those of corporate governance teams. And de facto delegation of proxy voting to ISS by many institutional investors ended up giving illegitimate power to proxy-advisory firms in corporate boardrooms.

We do not argue that institutional investors should take no action affecting corporations in which they have shareholdings. We point out that corporate managers (i.e., business-managing fiduciaries) and institutional investors (i.e., money-managing fiduciaries) differ in their basic functions. In addition, as fiduciaries of different types, each faces its own form of constraint. A problem of shareholder democracy lies in conferring upon institutional investors the stewardship of corporations without seriously questioning their ability and willingness to take it on. Business-managing fiduciaries and money-managing fiduciaries should communicate intelligently and honestly with each other by acknowledging their differences and explore common grounds for making a corporation a sustainable value-creating entity and extracting value such that it is distributed fairly among those who are involved in the process.

Many thanks to Jang-Sup Shin, Economics Professor, National University of Singapore, for this post — The Rhetoric and Reality of Shareholder Democracy — in response to my review of Predatory Value Extraction. I added the introduductory paragraph, the embeded links, tags, and graphic, as well as the links below. — James McRitchie

One Response to The Rhetoric and Reality of Shareholder Democracy

Thanks Professor Shin for your thoughtful comments. It is wonderful to have the opportunity for dialogue. Here are some quick thoughts back from me:

I’ve ordered Julia Ott’s book and look forward to the read. Regarding A Nation of Small Shareholders. I don’t think it suggested the 1950s ushered in anything like shareholder democracy. In fact, my main takeaway from the book was that the campaign to get small shareholders movement was simply an attempt by the NYSE to increase broker revenues, lower public resistance to decreases in capital gains and estate taxes, as well as means to bolster capitalism against the attractions of communism.

I certainly agree that large index funds and proxy advisors have a potentially large influence on corporations without having much incentive to go beyond a checkbox approach to ESG. Your advice to remedy the situation seems to be to abolish the obligation on institutional shareholders to vote. Additionally, you advocate that:

“Business-managing fiduciaries and money-managing fiduciaries should communicate intelligently and honestly with each other by acknowledging their differences and explore common grounds for making a corporation a sustainable value-creating entity and extracting value such that it is distributed fairly among those who are involved in the process.”

Before the obligation to vote and proxy advisory services were created, many funds either did not vote or routinely voted with management. At least now they ARE engaging with each other. Yet, funds lack both the incentive and expertise to do much to reinforce the idea that corporations would be sustainable value-creating entities.

One of my proposals to help address those issues is to require funds to announce their proxy votes in something close to real-time prior to annual meetings in a user-friendly format. If the SEC required such transparency, we could be picking our funds not only on the basis of historic returns and cost, but also on how well proxy voting by funds aligns with our own values. See my SEC Rulemaking Petition File 4-748. Funds would begin to compete on their ability to become value creating entities… or at least convince customers they are adding more value than their competitors.